Archive for April, 2012

Last week we discussed an interesting way to think about Delta (i.e., it is the percentage number that the market believes the option is likely to expire in the money). Today we will talk about how delta varies depending on how many weeks or months of remaining life it has.

Discussion of Delta, Continued:

Just in case you missed last week’s newsletter, Delta tells us how much the price of the option will change if the underlying stock or ETF changes by $1.00.

If you own a call option that carries a delta of 70, that means that if the stock goes up by $1.00, your option will increase in value by $.70 (if the stock falls by $1.00, your option will fall by a little less than $.70). Since each option is good for 100 shares, a price change of $.70 in the option means that the total value of your option has gained $70.

If a call option is deep in the money (i.e., at a strike price which is much lower than the stock price) and there are only a few days until it expires, the option is highly likely to finish in the money (i.e., at a higher price than the strike price). If SPY is trading at $140 with a week to go until expiration, a 130 call option would naturally have a very high delta (approaching 100). The stock would have to fall by $10 before it was no longer in the money, and that size move is unlikely in just a few days.

Owning a deep in-the-money call with only a few days until expiration is almost like owning the stock. If the stock goes up by a dollar tomorrow, the option is likely to go up by that amount ($1.00, or $100 since the option is for 100 shares of stock).

On the other hand, if the 130 option had six months of remaining life, a lot can happen over those six months. The delta value of the 130 call might be closer to 70 than it is to 100 since the stock is far more likely to fall by $10 if it has such a long time over which to change. If the stock goes up tomorrow and you own a call with six months of remaining life, you can only expect your option to gain about $70 in value.

The opposite occurs when the option is out of the money. At today’s option prices (which are a little lower than the historical mean average), with SPY at $140, the 143 call with one month of remaining life is 30. Owning that call is the equivalent of owning 30 shares of stock.

If the 143 option had six months of remaining life, the delta would be 45 at today’s option prices. The market is saying that there is a higher likelihood of that option finishing in the money since it has so many more months to fluctuate. Owning a 143 call with six months of remaining life is like owning 45 shares of stock.

Delta is one of the most important Greeks to understand about options. Just like most everything about options, it is not simple, especially since it changes depending on how close to the stock price the strike price is, and how much time is remaining in the option’s life.

This week we will start a discussion about the “Greeks” – the measures designed to predict how option prices will change when underlying stock prices change or time elapses. It is important to have a basic understanding of some of these measures before embarking on trading options.

I hope you enjoy this short discussion.

A Useful Way to Think About Delta

The first “Greek” that most people learn about when they get involved in options is Delta. This important measure tells us how much the price of the option will change if the underlying stock or ETF changes by $1.00.

If you own a call option that carries a delta of 50, that means that if the stock goes up by $1.00, your option will increase in value by $.50 (if the stock falls by $1.00, your option will fall by a little less than $.50).

The useful way to think about delta is to consider it the probability of that option finishing up (on expiration day) in the money. If you own a call option at a strike price of 60 and the underlying stock is selling at $60, you have an at-the-money option, and the delta will likely be about 50. In other words, the market is saying that your option has a 50-50 chance of expiring in the money (i.e., the stock is above $60 so your option would have some intrinsic value).

If your option were at the 55 strike, it would have a much higher delta value because the likelihood of its finishing up in the money (i.e., higher than $55) would be much higher. The stock could fall by $4.90 or go up by any amount and it would end up being in the money, so the delta value would be quite high, maybe 70 or 75. The market would be saying that there is a 70% or 75% chance of the stock ending up above $55 at expiration.

On the other hand, if your call option were at the 65 strike while the stock was selling at $60, it would carry a much lower delta because there would be a much lower likelihood of the stock going up $5 so that your option would expire in the money.

Of course, the amount of remaining life also has an effect on the delta value of an option. We will talk about that phenomenon next week.

Over the last two weeks, the market (SPY) has fallen about 3%, the first two down weeks of 2012. At Terry’s Tips, we carry out a bearish portfolio called 10K Bear which subscribers mirror if they want some protection against these kinds of weeks. They were rewarded this time, as usual, when the market turned south. They gained 45% on their money while SPY fell 3%.

10K Bear is down slightly for all of 2012 because up until the last two weeks, the market has been quite strong. If someone invested in all eight of our portfolios, however, their net gain so far in 2012 would be greater than 50%. How many investments out there do you suppose are doing that well?

10K Bear predominantly uses calendar spreads (puts) at strike prices which are lower than the current price of the stock. Today I would like to discuss a little about the choice of using puts or calls for calendar spreads.

Using Puts vs. Calls for Calendar Spreads

It is important to understand that the risk profile of a calendar spread is identical regardless of whether puts or calls are used. The strike price (rather than the choice of puts or calls) determines whether a spread is bearish or bullish. A calendar spread at a strike price below the stock price is a bearish because the maximum gain is made if the stock falls exactly to the strike price, and a calendar spread at a strike price above the stock price is bullish.

When people are generally optimistic about the market, call calendar spreads tend to cost more than put calendar spreads. For most of 2012, in spite of a consistently rising market, option buyers have been particularly pessimistic. They have traded many more puts than calls, and put calendar prices have been more expensive.

Right now, at-the-money put calendar spreads cost more than at-the-money call calendar spreads. As long as the underlying pessimism continues, they extra cost of the put spreads might be worth the money because when the about-to-expire short options are bought back and rolled over to the next short-term time period, a larger premium can be collected on that sale. This assumes, of course, that the current pessimism will continue into the future.

If you have a portfolio of exclusively calendar spreads (you don’t anticipate moving to diagonal spreads), it is best to use puts at strikes below the stock price and calls for spreads at strikes which are higher than the stock price. If you do the reverse, you will own a bunch of well in-the-money short options, and rolling them over to the next week or month is expensive (in-the-money bid-asked spreads are greater than out-of-the-money bid asked spreads so you can collect more cash when rolling over out-of-the-money short options).

The choice of using puts or calls for a calendar spread is most relevant when considering at-the-money spreads. When buying at-the-money calendar spreads, the least expensive choice (puts or calls) should usually be made. An exception to this rule comes when one of the quarterly SPY dividends is about to come due. On the day the dividend is payable (always on expiration Friday), the stock is expected to fall by the amount of the dividend (usually about $.60). Since the market anticipates this drop in the stock (and knowing the specific day that the stock will fall), put prices are generally bid higher in the weeks before that dividend date.

This bottom line is that put calendar spreads are preferable to call calendar spreads for at-the-money strikes (or even at strikes slightly higher than the stock price) coming into a SPY dividend date. Even though the put spreads cost more, the Weekly options that can be sold for enough extra to cover the higher cost. You do not want to own SPY call calendar spreads which might become in the money on the third Friday of March, June, September, or December because you will have to buy them back on Thursday to avoid paying the dividend, and you may not want to make that purchase to keep your entire portfolio balanced.

Spring is here in Vermont, well, almost. The recent two feet that resides outside my window is Old Man Winter’s last attempt at redemption after a poor showing this past winter. The market has essentially rallied for three straight months, but May is upon us and we have all heard the old adage “sell in May and go away’. Here are just a few stats that tend to back-up the phrase spoken frequently among traders and Wall Street over the past few weeks.

May is historically one of the weaker performing months. It is something to consider over the intermediate- term in this already overextended market. I looked at the historical average return of the S&P on a monthly basis over the last 60 years to see if actually backed up typical range-bound summer months also known as the “summer doldrums”.

The Stock Trader’s Almanac states that a $10,000 investment compounded to $544,323 during the November-April period over the last 56 years compared to a $272 loss for May-October. I think that sums up the significance of the historical period known as the “Summer Doldrums”.

Keep this in mind as we move into the summer months. Corrections happen. Flat periods happen. The market can’t continue to advance in this manner without corrections and lengthy consolidation periods. This is the nature of the market. Consider learning alternative investment strategies as a way to diversify your current portfolio so that you are better equipped in any market environment, bullish bearish or neutral.

Market Comments

U.S. stocks fell, sending the S&P 500 to its first back-to-back weekly decline since November, after employers added fewer jobs than estimated and investor concern over global economic growth intensified. The S&P 500 declined 2% to 1,370.26, its worst week since Dec. 16. The decline came even as the benchmark index for American equities had its best two-day gain of the year on April 11 and 12, sparked by optimism about earnings and signals from the Federal Reserve that interest rates will remain low. The Dow lost 210.55 points, or 1.6 percent, to 12,849.59.

All 10 groups in the S&P 500 also slipped after China’s gross domestic product slowed more than forecast. Financial shares fell the most, sinking 2.8%, as Bank of America tumbled 6%. Apple sank 4.5% for the biggest weekly loss since October.

“There are still macro concerns that are weighing on the market right now,” Joseph Veranth, chief investment officer at Dana Investment Advisors in Brookfield, Wisconsin, said in a Bloomberg interview. “Economic numbers haven’t gone off a cliff, but the key is they are a little weaker than people expected,” he said. China and Europe “are concerns for us as part of the overall puzzle.”

Worries over the health of Spain came to a head on Friday after it was reported net borrowing by Spanish banks from the European Central Bank surged to 228 billion in March from 152 billion in February. The news sent Spanish CDS up to a record high, and caused its 10-yr yield to climb back above 6.00%.

Technical Mumbo Jumbo

The top that has been forming in the S&P 500 since mid-March looks quite bearish at the moment. Thursday surge followed by a sharp decline Friday really took the bulls by surprise and took the air out of their sails.

However, if the bulls can manage to muster one last push through 1400 then a case for continued bullishness can be made. Until then I will be watching carefully to see if the S&P can push below 1350 and then 1330. If we see a decline through 1330 then test of 1300 looks likely.

For several weeks now, I have been sharing my thoughts about trading options in Apple (AAPL). During this time, two actual portfolios we carry out at Terry’s Tips have averaged double-digit gains every week. No wonder we love the stock.

Today I would like to share something we have noticed about how AAPL fluctuates in price during the week, and a likely explanation for this pattern.

Interesting AAPL Price Change Pattern

We carry out two actual portfolios at Terry’s Tips which use AAPL as the underlying stock. Many of our subscribers mirror these trades in their own account or have thinkorswim execute trades for them through their Auto-Trade program. (By the way, this Auto-Trade program will not be available for new thinkorswim clients until after the May options expiration due to their integration with TD Ameritrade.)

The first portfolio is called William Tell. It uses what we call the Shoot Strategy (as in shoot for the moon). It is different from our major strategy which does not try to guess which way the market is headed. The Shoot Strategy is designed to significantly outperform the purchase of stock for a company you believe is headed higher. Since we selected AAPL as the underlying, you can guess why we call this the William Tell portfolio.

Last week, as you probably know, was a great one for AAPL. It shot up by $34.13 (5.7%). Our William Tell portfolio gained a whopping 37.4%, or about 6 times as great a change as the stock enjoyed. Since we started the William Tell portfolio on April 9, 2010 (exactly two years ago today), the stock has gone up by 137% while our portfolio has gained 810%, almost 6 times greater than the stock went up. This is not just a hypothetical gain. It is in an actual account and includes all commissions.

The second portfolio that currently uses AAPL as the underlying is called Terry’s Trades. It was started in October 2011 to mirror the same trades that I am making in my personal account. In the first few months of operation, this portfolio invested in strangles and straddles on SPY and the Russell 2000 (IWM), and some volatility plays (trading XIV and VXX), and about two months ago, switched to trading AAPL options (mostly buying the first month out and selling Weeklys against those long positions).

In the six months of operation for the Terry’s Trades portfolio, it has gained 294%, after commissions, of course. Much of this gain was due to the recent performance of the AAPL options.

Over the last two months, we have noticed an interesting pattern in how the price of AAPL changes (and checking back over the past several months for the monthly expiration Fridays). The pattern is simply that on Fridays, the price of AAPL often falls, and on Mondays it goes back up. A week ago, March 30, it fell $10, and on Monday, April 2, it rose by almost that exact same amount, for example.

There may be a simple explanation for this pattern (by the way, the pattern was even more consistent on the third Fridays of the month when the monthly options expire). Many people are bullish on Apple, but the cost of the stock is so expensive that they only have enough cash to buy calls on the stock rather than the actual shares. When more people are buying calls than they are puts (as is the case in AAPL options), the people who are selling those calls are the market makers.

Market makers (I know, since I used to be one) seek at all times to have a delta-neutral portfolio which means that they want to be in a position where they don’t care whether the stock goes up or down. If they end up with a large number of short calls in their account, the easiest way to balance their risk is to buy stock. When they go into the market and buy stock, the price naturally rises.

On Fridays when the Weekly calls expire (and more importantly, on those third Fridays when the regular monthly options expire), the market makers are no longer short all those calls, and they can sell the stock to balance out their portfolios. When they do this, the stock falls in price. On Monday, new call buying might take place, and they once again have to go into the market and buy stock to balance things out once again.

We don’t know for certain that this is what is happening, but the pattern is quite persistent. We have been taking advantage of this pattern in our portfolios. On March 30, for example, when we normally roll our short Weekly calls over to the next week, we did nothing. Instead, we waited until Monday to sell new calls, and when we did, the price of the stock had gone up almost $10, and we got much higher prices for the calls that we sold.

Happy trading if you choose to duplicate what we are doing. Of course, you should never risk money that you can’t afford to lose.

The S&P 500′s loss for the week of 0.7% was its biggest weekly decline of the year as yields on Spain’s debt climbed higher and its equity market hit lows not seen since the height of the euro zone’s crisis last year.

But the question is, will this past week’s losses carry into next week? Is the latest decline a sign of things to come?

Well, on Friday the U.S. Labor Department said employers added 120,000 jobs, the fewest in five months and less than the median economist forecast of 205,000 economists’ predicted. The amount had exceeded 200,000 for three straight months.

“This is a real shock,” Donald Selkin, the New York-based chief market strategist at National Securities Corp., which manages about $3 billion, said in a telephone interview. “Everybody is so hung up on the 200,000 increase.”

After the S&P 500′s rise of about 30% since October, there is concern that buying interest is not strong enough to drive further gains, particularly after soft March U.S. employment figures were released on Friday.

“It seems like we’re hitting resistance,” said Jack Ablin, chief investment officer of Harris Private Bank in Chicago. “I think the market will grind higher, but it will be at a much slower pace. Earnings and jobs aren’t helping.”

But earnings begin next week and they are definitely the wild card for how the market will perform over the next month or so.

Warnings have dominated the pre-earnings season. Of the 121 pre-announcements, 68% are negative ones, compared with 58 percent in the first quarter a year ago.

“Earnings are expected to be weak this quarter, and if you strip out Apple, the picture is even worse.

That could be a big headwind, especially at a time when the macro environment is less than friendly.”
One thing is certain, with futures already down over 1% heading into next week we should be in store for some much needed volatility.

This week I would like to tell you the results of the AAPL spread idea I told you about last week.

Update on Another AAPL Spread Idea

Last week I suggested buying 3 AAPL calendar spreads (buying April-12 options and selling Mar5-12 options) at the 595 strike price (using puts) and the 600 and 605 strike prices using calls, and to increase all these strikes by $5 if the stock opened up about $5 higher on Monday (which it did).

I purchased these calendar spreads in my own account at the 600, 605, and 610 strikes, paying an average of $11.50 ($1150), slightly higher than I expected they would cost in last week’s report.

When AAPL fell by $10.30 on Friday, all of my short call options expired worthless and I had to pay $.50 ($50) to buy back the about-to-expire Mar5-12 600 put. The value of my remaining April-12 options were $16.85, $14.45, and $12.30, and my net gain after commissions was $905, or about 38% on my $3500 investment. Not bad for a week’s effort.

The gains I made were remarkably similar to those that the risk profile graph I included last week said they would be. That gives me confidence in those graphs I refer to every day and display for my paying subscribers each week.

In spite of AAPL being essentially flat for the week, the Terry’s Tips portfolio which has traded this company exclusively for almost two years has now gained 703% over that time period. It is our most successful portfolio.

I think the exact same spreads I suggested last week could be placed again this week, this time selling the Apr1-12 Weeklys and buying the Apr-12 monthlys. The spreads should be less expensive this week (averaging about $8.50 per spread rather than $11.50.

Happy trading if you choose to duplicate those positions. Of course, you should never risk money that you can’t afford to lose.

We have made 3 short videos which explain the 3-week results of our AAPL trading. The original positions were set out in an actual account carried out at Terry’s Tips. The YouTube link is http://youtu.be/6J9KPuimyXk

Success Stories

I have been trading the equity markets with many different strategies for over 40 years. Terry Allen's strategies have been the most consistent money makers for me. I used them during the 2008 melt-down, to earn over 50% annualized return, while all my neighbors were crying about their losses.